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Death by Short VIX?

Shorting volatility has been a great trade but what are the risks?

Zerohedge posted an article titled "People Are Going To Be Wiped Out" By Short-VIX ETFs.” It is an excellent read that starts out describing a fortune made by a do-it-yourselfer who turned $500,000 into $13 million by shorting VIX every time it jumped higher. It does not specify whether he used inverse VIX ETFs or used futures. The article goes back and forth talking about ETFs and futures, not that they don’t know the difference between the two, but it makes it a little harder to follow.

The idea of shorting volatility is straightforward. VIX has been moving from the upper left as Dennis Gartman might say, down to the lower right for many years. ETFs and ETNs that go long VIX one way or another have lost 99% of their value; “Going back to 2009, the price of the ETF has gone from $120,000 a share to just $35.” If you are unfamiliar, the long VIX funds reverse split every so often.

In addition to the trend for a lower VIX working against funds that are long VIX, the pricing structure of the futures curve is often in contango (as futures contracts expire they are replaced by more expensive contracts). Time a purchase correctly, or luckily and there is money to be made but much of it would boil down to guessing when a spike in volatility is going to occur.

So, if going long the VIX with a fund like this essentially can’t work then a fund that goes short the VIX must be like printing money….so the thinking goes. One of the two biggest inverse VIX products is the Credit Suisse AG - VelocityShares Daily Inverse VIX Short Term ETN (XIV) which year to date is up 154% and in the last five years is up 523%. Clearly, shorting volatility has been a good trade.

The concern in the article about all of this seems to relate more to collateralizing futures contracts. According to the article Interactive Brokers takes a very conservative route, requiring customers to “post between 300%-400% margin when they short certain VIX contracts.” The logic is simple enough. VIX is now at 10, if it goes to 40 and an investor only has the normal 50% margin they could be in serious trouble (wiped out/negative equity) but not if they are collateralized to 40.

A bigger concern (as I read it) is the systemic threat posed if something goes wrong. The article questioned where there is enough capital to make good on some sort of 10 standard deviation event with the underlying index. The market for VIX futures is big and getting bigger and a dramatic rate. The concern as follows;

Should the VIX suddenly spike, the repercussions of such a move would be further complicated by the billions of dollars sitting in various VIX-linked ETFs. Because individual sellers would probably disappear from the market in such a situation, the ETF market makers would find it nearly impossible to hedge their positions, potentially triggering the dissolution of the funds, or even the collapse of some of these firms.

Take it easy everyone. Credit Suisse, Barclays and ProShares, the big players in the VIX ETP space, all have $1 billion in the couch cushions. There are a couple of small players in the ETP market though and taken to some extreme, sure something really bad is possible but not probable (this has nothing to do with whether the trade might go bad, it very well could). Where one broker has increased margin requirements there will be others. A spike in volatility would not be a black swan or even a grey swan….systemically. At the margin there could be smaller firms that mismanage such an event without sufficient deep pockets to recover, wouldn’t doubt it but a small enough firm in theory could always be a trade or two away from oblivion. Yes, big firms have gone under before but looking for 2008 to happen again is a dead end. Despite Zerohedge’s bias to find a financial apocalypse in each tick of every market, the next crisis will be its own event not some past crisis all over again.

In terms of buying any VIX exchange traded product, you’re obviously not early if you choose to speculate on a short VIX product. To the Zerohedge headline, you’re only at risk of losing what you put in. It would be hard to believe that there are too many people putting half their money into an inverse VIX ETN. If you are a trader, then just like anything else, once you understand the market mechanics, these are trades that you will either get right or get wrong. If you’re an investor just trying to have success versus your financial plan, I doubt that plan includes speculating on volatility.

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